Alternative Lending Being Given a Boost

Written by: Laurie Kulikowski02/16/12 - 7:45 AM EST

NEW YORK ( MainStreet) -- Even as credit starts to flow again timidly at traditional lenders, small businesses -- particularly start-up companies -- are still having trouble getting financing. Many have turned to alternative lenders. And now bigger, more recognizable names finally smell opportunity in the alternative lending space.

Small-business loan approval rates by community banks and nonbank lenders spiked in January to their highest levels in the past 12 months, according to the monthly Small Business Lending Index , which analyzes loan applications through Biz2credit.com, which connects borrowers with more than 1,100 lenders nationwide.

Alternative lenders approved more than two-thirds of applications from potential borrowers last month, compared with some 11.7% at big banks, a Biz2Credit survey says.

Alternative lenders in particular -- Community Development Financial Institutions, accounts receivable financers, merchant cash advance companies, microlenders and others -- approved more than two-thirds of applications from potential borrowers last month. That compares with the approximately 47.5% of loan applications approved by small community banks and just 11.7% approved in January by banks with more than $10 billion in assets, Biz2Credit says.

"Over the last three and a half years, a lot of banks have shrunk their branch network. That has disrupted the old relationship dynamic and created a huge vacuum in the market for working capital for businesses to run their day-to-day business," Biz2Credit CEO Rohit Arora says.

Additionally, SBA programs -- particularly the SBA Express program more geared toward working capital -- "really suffered because of the fact that the bigger banks were the main users of that program. So that created a double whammy and no way for small businesses to get the money," Arora says.

That led to the rise of alternative lenders. Initially it was some of the CDFIs, microlenders and credit unions, types of lenders without much experience in such things as cash advances and factoring, Arora says.

"Over the last year what we are starting to see is that kind of funding is coming from more mainstream lenders because of all these different reasons. It is also creating the pressure on the banks and other institution to go out and start lending again to businesses," Arora says.

The main difference between alternative lenders and more traditional lenders is the terms of the funding. Typically, money is available quickly, but borrowers pay much higher interest rates. "Normally the downside of this money is it's more expensive," Arora says. "The market is not regulated, so there is no cap on the interest rates. This usually leads to more defaults and more businesses going out of business just from the fact that the cost of capital is so high."

That's changing. The cost of funding in this asset class has begun to drop from an average 27%-28% to 16%-18%, Biz2Credit says. As more players enter the niche, interest rates will lower even further as competition heats up.